Question

# You were hired as a consultant to AICC Company, whose target capital structure calls for 30%...

1. You were hired as a consultant to AICC Company, whose target capital structure calls for 30% debt, 5% preferred, and 65% common equity. The Company’s common stock currently sells at \$20 per share and just paid \$1 annual dividend per share (D1). The dividend is expected to grow at a constant rate of 5% a year. (10 pts)

1. Using the DCF model, what is the company’s cost of common equity.
1. If the firm’s beta is 1.2, the risk-free rate ,rfr , is 5%, and the average return on the market, rm, is 11%, what will be the firm’s cost of common equity using the CAPM approach?
1. If the cost of debt, rd, is 8% and the risk premium, RP, is 3%, then what is the cost of common equity using the bond-yield-plus-risk-premium approach.
1. Which cost of equity (rs) will you be using to calculate the WACC. Hint: the average.
1. If the company’s cost of preferred stock, rp, is 6% and tax rate is 35%, what is the company’s WACC?

a). Cost of equity (using DCF model) = (D0*(1+g)/P0) + g

where D0 = current dividend = 1; g = growth rate = 5%; P0 = current share price = 20

Cost of equity = (1*(1+5%)/20) + 5% = 10.25%

b). Cost of equity (using CAPM) = risk-free rate + beta*(market return - risk-free return)

= 5% + 1.2*(11%-5%) = 12.20%

c). Cost of equity (using bond yield plus risk premium approach) = yield of the bond + risk premium = 8% + 3% = 11%

d). Cost of equity for calculating the WACC = average of all the three costs calculated above = (10.25%+12.20%+11%)/3 = 11.15%

e). WACC = sum of weighted costs of capital

= weight of equity*cost of equity + weight of preferred stock*cost of preferred stock + weight of debt*cost of debt*(1-Tax rate)

= 65%*11.15% + 5%*6% + 30%*8%*(1-35%) = 9.11%

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